The relationship between regulators and financial institutions can be described in many ways, but one would not be to call them allies. While it is not totally antagonistic, it is also not like a partnership.

Regulators have an objective to protect the financial system and minimize taxpayer costs. A very large part of their efforts, other than to prevent fraud, constitutes protecting institutions from extreme tail risk and drawing regulatory boundaries and limits. Tail risk refers to exposure from uncertainty that is so high that — if it materializes — it can turn into catastrophic losses and overwhelm institutions.

Financial institutions view such boundaries and limits as overly restrictive, even though institutions also have a fiduciary objective to protect themselves from extreme tail risk. Despite this common objective of protection, there is an apparent divergence of interests because of how each side goes about achieving this objective. (Click here to read more …)